Will a slump hit Labour in 2002?

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This may seem a touch premature, but let's think about the election in 2002. The only sensible working assumption now is that Labour will form the next government and while it is not at all clear that it will achieve a majority this time round, it ought to be able, maybe after a second election, to continue into the early part of the next century. It will therefore, one way or another, have four or five years in which to establish a track record of economic competence - a necessary though insufficient condition for re-election.

In any case, it is not premature for all the companies trying to plan their business over the next five years - the sort of timescale on which many businesses now operate. They have to think through the economic cycle so that their plans match the swings of the economy: they have to make a judgement not just about the trade and interest rate cycles, but also about the response of the government of the day towards them. It matters to companies, too, that the government should deliver economic competence but the punishment is perhaps not quite so severe for them if it fails.

The starting point for this election is an economy well into a long expansion - in contrast to the previous election which came pretty close to the bottom of the cycle. It is a harsh fact of economic life that growth does not proceed steadily forever.

Over the last 30 years, through governments of both parties, the fluctuations in the UK economy have tended to be larger than those of the other Group of Seven countries because we have been relatively poor at macro-economic management. But even assuming improved performance from now on, there will still be an economic cycle. The most likely shape of that cycle will be reasonable rapid growth this year and next but then slowing thereafter. However, that is only the most likely pattern, for there are dangers en route.

The first of these raises a practical question which we have heard posed a lot in the last few weeks: what is the true state of public finances? After the last budget in November there was widespread scepticism over whether the Government would meet its spending targets - and hence its borrowing target - without putting up taxes. Then a couple of weeks ago Gordon Brown announced that he would stick to the Government spending plans for the first two years of a new parliament and he would not increase the general tax burden either. Result: Messrs Clarke and Brown found themselves accused of being either knaves or fools. Taxes, the cry goes, will have to go up after the election and both the Chancellor and his shadow are lying when they deny that. Are they lying?

I may be in a minority of one in the country, but I would trust both of them.

Sure, there is a problem. Projections for public spending are undoubtedly tight. The stories last week that the public sector pay review bodies were recommending higher-than-budgeted pay awards seem to confirm that it would be very difficult to meet the targets, since salaries are such a large part of the spending cake.

For a start there is a difference between public spending targets being tight and being unattainable. If you are spending pounds 270bn of other people's money its seems not unreasonable to be able to find the odd pounds 7bn of savings. It is like saying to someone spending pounds 27,000 a year after tax (say, earning pounds 35,000 or more gross) that he or she has to find savings of pounds 700: disagreeable, but surely do-able.

In any case, the largest single component of public spending is social security and that is powerfully affected by the level of unemployment in the economy. No-one knows how low unemployment can go but all the projections of unemployment of five years ago have proved too pessimistic. And of course, the longer the expansion continues and the closer the economy can be run to full capacity, the higher the tax revenues.

Maybe the Treasury is being too optimistic about the fall in public sector borrowing, but as the graph on the left shows, a reputable City forecaster like NatWest Markets still sees the PSBR below 3 per cent of Gross Domestic Product in the coming financial year: and it is basing that on the assumption of Labour winning the election.

Now I should also record that the team at NatWest Markets do not quite believe the Government spending plans and take the mainstream view that personal taxes will indeed go up in 1998/9. But if that is right, note that it will be against a background of slowing economic growth and maybe rising unemployment - though I think that may be a bit early and the rise will come later.

The next two graphs show some forecasts for GDP and unemployment. You can see how the present surge continues through this year, peaking in the autumn and then falling back during 1998. In the final quarter of 1998 we get the first rise in unemployment. The growth during this year and next, the NatWest team suggests, will start to push the current account back from its present near-balance to a deficit of pounds 4-5bn a year. That would be manageable - it would be smaller as a proportion of GDP than Germany's current account deficit at the moment - but any further deterioration would start to cause concern.

The forecasts do not extend beyond the end of next year for the very sensible reason that economic predictions stretching more than two years ahead are pretty fictional. Still, you can glimpse the possible position as the economy goes into 1999: slowing growth, rising unemployment, a slightly disturbing balance of payments situation. And it does not take much imagination to see the political mood if that downturn gathered pace through 1999 and into 2000, particularly if I am wrong about personal taxation and poor Mr Brown, if he has not been shuffled into some other job, finds himself nudging up tax rates. At best it would be mid-term blues.

Now lets look a little further ahead and assume that macro-economic management is rather better under Labour than it has been under the Tories. Let's assume that this year and next, the Treasury and the Bank of England between them do manage to shave off the peak of the boom by pushing up interest rates. Let's assume that growth comes down slowly through 1998 and 1999. There will probably not be much of an increase in personal incomes in 1999 and 2000. By then the economy, if not in recession, will probably still be growing below its productive potential. Even if the government of the day gets its macro-economic policies reasonably correct, unemployment could still be rising in 2001 - albeit from a lower base than in previous cycles.

The point is very simple: we had an election in 1987 towards the top of the boom. We had another one in 1992 at the bottom of the slump. We are having one in 1997 well into, if not a boom, several years of solid growth. And when we have one in 2002, we may well find that we are back into something close to recession - or worse.

Voters clearly do not make their minds up purely on the basis of whether the economy is in a boom or slump. But to get a second term, a new Labour government will have to manage the economic cycle with sensitivity. It would not be easy for Labour to fight an election with unemployment going up; and for purely cyclical reasons, there is a good chance that come 2001, that is exactly what will be happening. If, in addition, we are paying more tax, we will be very grumpy indeed.